Once people have built up the capital or held the real cash or real bonds the government can extract revenue without disincentive effects. of course the distortions arise--for capital, money or bonds--when people anticipate ex ante, the possibility of these capital levies, ex post. That's why these forms of raising revenue will not end up being so desirable in a full equilibrium where people form expectations rationally. But, for the moment e just listing the benefits that attach, ex post, to surprise inflation The Costs of inflation The second major element in our model is the cost of inflation, Costs are assumed to rise, and at an increasing rate, with the realized infla tion rate, T. Although people generally regard inflation as very costly, economists have not presented very convincing arguments to explain these costs Further, the present type of cost refers to the actual amount of inflation for the period, rather than to the variance of inflation, which could more easily be seen as costly. Direct costs of changing prices fit reasonably well into the model, although the quantitative role of these costs is doubt ful. In any event the analysis has some interesting conclusions for the case where the actual amount of inflation for each period is not perceived as costly. Then, the model predicts a lot of inflation! The setup of our Exampl Le We focus our discussion on the simplest possible example, which illus- trates the main points about discretion, rules and reputation. Along the way, we indicate how the results generalize beyond this example The policymaker's objective involves a cost for each period, z, which-5— Once people have built up the capital or held the real cash or real bonds, the government can extract revenue without disincentive effects. Of course, the distortions arise--for capital, money or bonds--when people anticipate, ex ante, the possibility of these capital levies, ex post. That's why these forms of raising revenue will not end up being so desirable in a full equilibrium where people form expectations rationally. But, for the moment, we are just listing the benefits that attach, ex post, to surprise inflation. The Costs of Inflation The second major element in our model is the cost of inflation. Costs are assumed to rise, and at an increasing rate, with the realized infla￾tion rate, ir. Although people generally regard inflation as very costly, economists have not presented very convincing arguments to explain these costs. Further, the present type of cost refers to the actual amount of inflation for the period, rather than to the variance of inflation, which could more easily be seen as costly. Direct costs of changing prices fit reasonably well into the model, although the quantitative role of these costs is doubt￾ful. In any event the analysis has some interesting conclusions for the case where the actual amount of inflation for each period is not perceived as costly. Then, the model predicts a lot of inflationl The Setup of our Example We focus our discussion on the simplest possible example, which illus￾trates the main points about discretion, rules and reputation. Along the way, we indicate how the results generalize beyond this example. The policymaker's objective involves a cost for each period, z, which